IS/LM/BP Model Flashcards
What is the IS/LM/BP Model?
An extension of the Keynesian IS/LM model for an open economy.
Developed by Mundell and Fleming. Adds the Balance of Payments (BP) curve to account for international trade, capital flows, and exchange rate regimes.
What are the key assumptions of the IS/LM/BP model?
Short-run model with fixed prices. Economy is demand-driven, not supply-constrained. Perfect capital mobility. Exchange rates can be fixed or flexible. Focus is on policy effectiveness under different regimes.
What do the curves in the IS/LM/BP model represent?
IS: Equilibrium in the goods market. LM: Equilibrium in the money market. BP: Equilibrium in the Balance of Payments.
What are flexible (floating) exchange rates?
The value of currency is set by market forces. Central Bank does not intervene.
What are fixed exchange rates?
The Central Bank pegs the exchange rate and must intervene to maintain it, by buying/selling currency.
What does the Balance of Payments (BP) curve show?
The BP curve shows combinations of income and interest rates where the external sector is balanced.
With perfect capital mobility, the BP curve is horizontal. If domestic interest rate > world rate → capital inflows → BP surplus. If domestic interest rate < world rate → capital outflows → BP deficit.
Is fiscal policy effective under flexible exchange rates?
No, it is ineffective.
Higher government spending leads to higher interest rates, causing capital inflow and currency appreciation, which results in reduced exports.
Is fiscal policy effective under fixed exchange rates?
Yes, it is effective.
The Central Bank intervenes, increases money supply, supports fiscal expansion, leading to further income rise.
Is monetary policy effective under flexible exchange rates?
Yes, it is effective.
More money leads to lower interest rates, causing capital outflow and currency depreciation, which increases exports and income.
Is monetary policy effective under fixed exchange rates?
No, it is ineffective.
The Central Bank must reverse any monetary expansion to defend the fixed exchange rate, restoring original income levels.
What is the role of the Central Bank under flexible rates?
The Central Bank does not intervene in the currency market.
What is the role of the Central Bank under fixed rates?
The Central Bank must buy/sell currency to keep the exchange rate constant, affecting the money supply.
What is the Trilemma (Impossible Trinity)?
A country can only achieve two out of the following three goals: Fixed Exchange Rate, Free Capital Movement, Independent Monetary Policy.
You cannot have all three. For example, if you want fixed exchange rates and capital mobility, you must give up monetary independence.
What is the summary of policy impacts under flexible rates?
Fiscal Policy: Ineffective. Monetary Policy: Effective (currency depreciates).
What is the summary of policy impacts under fixed rates?
Fiscal Policy: Effective (CB supports it). Monetary Policy: Ineffective (CB offsets it).
